This paper characterizes optimal income tax and audit schemes in the presence of costly enforcement when the agent is risk averse and not necessarily risk neutral. It is shown that the results under risk-neutrality (Chander and Wilde (1998)) largely hold under risk aversion. We first show that in an optimal scheme the tax evasion decision of the agent is equivalent to risking his entire income against a possible gain in terms of lower tax payment. We then introduce a measure of aversion to such large risks. In contrast, the Arrow-Pratt coefficients of risk aversion measure aversion to small risks only. We show that the optimal tax function is non-decreasing and concave if the agent’s aversion to large risks, as defined in terms of our measure, is decreasing with income. The optimal audit function is non-increasing and the audits may be random or deterministic.
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Find related papers by JEL classification: D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
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